Cezary Salad

On April 27th, the US Senate, power of subpoena in hand, brought to its chambers executives from the world’s most powerful financial firm, Goldman Sachs, to testify on the cause of the biggest financial meltdown in decades – and their role in contributing to the disaster.

Eleven hours of testimony later, comedians had much more material for late night jokes and the Democrats had much more momentum for their financial reform bill.

But key questions about the financial crisis and Goldman’s activities remained unanswered, and solid financial reform is still far from certain.

It’s easy enough to see why. Take a look at the video from the hearing and you’ll hear Senators trying over and over again to get Goldman chief Lloyd Blankfein and other executives to admit that the firm had a conflict of interest vis-à-vis its clients. Reams of documents, hand-picked by the Senate’s Permanent Subcommittee on Investigations, were designed to show that the firm had shorted, or bet against, the US’ residential mortgage market, even though it was helping clients structure the opposite bet.

“You went short – big time,” Democrat Carl Levin of Michigan, the committee chairman, told Blankfein in his concluding remarks. “You don’t want to acknowledge it, I know. But that’s what your documents show.”

Now, why couldn’t Chairman Levin just get Blankfein to say as much? Or to just give up and say, “you’re right - we’re conflicted?” After all, the SEC had just accused the firm of committing fraud by not disclosing to one of its clients, German bank IKB, that Goldman had let another client influence the selection of a portfolio of mortgage-backed securities that IKB had bet on. IKB suffered heavy losses when the so-called “Abacus” portfolio went bad, while the other client, hedge fund Paulson & Co., got $1 billion off its short position and paid Goldman a $15 million fee in exchange for structuring the deal.

I think the reason Goldman was so coy – and why the committee wasted its time trying to corner the firm into admitting conflicts – boils down to something simple I heard a hedge fund manager say on the same night of the Goldman testimony.

I was at an event in New York (“Forgotten Lessons of Finance 101” put together by Ed Grebeck, a structured finance lecturer at the NYU School of Continuing and Professional Studies) where James Chanos, the short hedge fund manager famous for spotting the Enron collapse in 2001, was sharing his views.

I asked him what he thought about the SEC’s lawsuit against Goldman; he declined to comment on Goldman or the lawsuit, but he did make one remark that really put the hearing in perspective:

“I think Wall Street generally has a real, inherent problem . . . with conflicts of interest,” he said.

He pointed to equity underwriting as an example. “At its basic heart, in equity underwriting, is a conflict of interest because on the one hand you’re telling your corporate client, ‘this is a good time to raise equity money, it’s cheap, the ducks are quacking, feed them’ . . . on the other hand, you’re then telling your investment clients that this is a good deal.”

That doesn’t mean it’s all hopeless: “we build upon that and we have Chinese walls and we deal with it,” Chanos said. But it doesn’t take away from the basic fact that big investment banks of any stripe face very serious and real conflicts of interest that they have to work real hard to mitigate.

Which is why Goldman wasn’t going to go before the Senate and say anything that would indicate that it’s different from the rest of the pack by being conflicted with its clients. Democratic Senator Claire McCaskill of Missouri at least acknowledged that it wasn’t fair to single out the firm. But she still proceeded to ask the same leading questions aimed at cornering the firm’s executives into admitting conflicts of interest as all the other Senators.

Instead, here are three hard-hitting questions the Senators could have asked which, rather than trying to expose conflicts which are endemic to investment banking, could have given us a much better understanding of how to regulate the industry (fair disclosure - I used to work in investment banking and once interviewed with Goldman for a position):

1) Goldman said in response to the SEC lawsuit that it actually lost money on the Abacus deal with Paulson and IKB. Sure – they got $15 million, but lost $90 million on the transaction overall.

But how much money did the firm really make on the transaction?

Investment banks are very crafty when it comes to fees. Various divisions of an investment bank will work on one deal together and book fees from their individual contributions, though the bank may not (and often does not) disclose all the fees. Why? Because investment banks don’t have to. And if they did, telling their clients that they actually made many multiples more money than they said they did wouldn’t exactly make them look good.

Now, flip through the sales document for the Abacus deal (available here) and you’ll note on page 50 that different parts of Goldman provided interest rate hedges and collateral services for the transaction – fees that may not be included in the $15 million Goldman earned from Paulson.

So one thing the Senate could do to make the industry more transparent would be to require more transparency on fee disclosure and income reporting from all divisions working on a particular deal. Once investors see where the money is, they can make better choices about who to invest with and how to align interests.

2) Goldman’s lawyers said that ACA Capital, the third party it had contracted to select the securities in the deal, ended up not picking many of the mortgage securities Paulson suggested for inclusion in the Abacus pool. Paulson suggested 123 mortgage-backed securities but “ACA rejected more than half of the securities, and sent Goldman Sachs a revised spreadsheet listing 86 securities, including 55 from the list of 123,” the lawyers wrote in a letter to the SEC last year.

So don’t you think that the Abacus portfolio was doomed fail from the beginning?

The reason this is important is because Paulson wanted to take a short position on the deal. So obviously, the more of these securities they packed into the Abacus transaction vehicle, the better. But the structure of deals like Abacus – called synthetic collateralized debt obligations – is such that it doesn’t take many homeowners to stop paying before the equity in the transaction becomes worthless. Those 55 securities were most likely more than enough to poison the whole transaction for IKB from the outset. So Paulson’s influence on the deal may not be as small as Goldman claims it is.

The larger point:  investment banks who participate in these types of transactions can simply hide behind the fact that they are dealing with “big boys” – large, sophisticated institutional investors who know what they’re doing. But as the Abacus deal clearly shows, investors like IKB aren’t as sophisticated as they’re made out to be. Perhaps there’s a need to revisit this defense and require more disclosure where needed.

3) Goldman’s co-general counsel, Greg Palm, said on a conference call with reporters after the SEC filed its lawsuit that if Goldman “had evidence that someone here was trying to mislead someone, that’s not something we’d condone at all and we’d be the first to take action.”

But did Goldman notice the activities of the investment banker in question, Fabrice Tourre, and simply not think they were misleading or did it not notice his activities at all?

The latter option doesn’t seem like a big possibility since there are two ways to get noticed by your superiors in the world of investment banking: make a lot of money, or make very little money. If you make very little money, you’ll likely get fired. But if you make a lot of money, clearly, there is an incentive to keep you on and let you keep doing what you’re doing.

And Tourre was doing well. Anyone who brings in a $15 million fee on a single deal at the age of 27 is going to get noticed, whether it’s at Goldman or any other investment bank. And superiors will have an inherent incentive to overlook questionable dealings if overall they come out ahead on the deal. With each deal, you stretch a little more and take another step into whatever activity is minting the gold, until – like Lehman Brothers or Bear Stearns – you end up going under and are mired in lawsuits for ethical breaches.

Luckily, Goldman was able to escape that fate and is now going to re-examine its business practices. But that’s as clear an indication as any that there is a need for more accountability in investment banking from the top down and better supervision of twenty-somethings inking complex, billion-dollar deals.

With that in mind, none of the panelists at the “Finance 101” event were happy with the structure of the current financial industry reform package being championed by Democratic Connecticut Senator Chris Dodd.

“It doesn’t go far enough,” Chanos said, referring to the Dodd bill.

With hearings like these, I don’t wonder why.

It’s rare to pick up the paper on the way to lunch with someone and find a story that prepares you precisely for the conversation you’re about to have. But that’s what happened to me a few days ago when I read the New York Times on the way to a lunchtime meeting with Ed Grebeck.

Grebeck specializes in a subject of great interest to me – structured finance– and we were meeting to discuss how, more than two years after the outbreak of the financial crisis, not much, if anything, had been done on the regulatory front to make sure that the mistakes of the past don’t happen again.

The Times’ Friday business columnist, Floyd Norris, just happened to have a piece in the paper (yes, I still subscribe to print) that day on MBIA’s lawsuit against Merrill Lynch. The fallen investment bank was a big client of MBIA during the go-go days before the mortgage bubble bust, when it paid the financial insurer to take the hit if any of its mortgage-backed securitisations should ever go sour (so-called credit default swap contracts).

MBIA wrote $5.7 billion worth of these for Merrill at extremely low fees of .08% annually, according to their complaint – all based on assurances from Merrill and credit ratings from Moody’s and S&P that the securities it was insuring were indeed the “highly conservative super-senior,” “above AAA credit quality” debt instruments they thought they were. No credit analysis whatsoever by MBIA of the securities’ underlying assets. In other words, as Norris indicates, it’s another “I didn’t do my homework” lawsuit that’s bound to become a chapter in someone’s book on how the whole financial meltdown started in the first place.

Grebeck got a chuckle out of the story since it wasn’t anything new to him. It was two years ago this month that he, hedge fund managers Bill Ackman and James Chanos and Yale Law School’s Jonathan Macey held panel during which they warned that financial guarantors like MBIA were increasingly dependent on credit rating agencies for their AAA franchises and weren’t doing enough of the homework themselves to make sure guarantees they were making would have the payout rates they expected.

The result was one giant, systemic fallacy of equivocation, where one term with two different meanings is used in a single argument. The argument was: these are AAA-rated securities, so they must be safe. How safe? Well, they wouldn’t be rated AAA if they weren’t as safe as other banks or corporate that earn the same rating, so they must be of the same credit quality – even though they weren’t. As Grebeck points out, in corporate credit there is recourse to secondary sources of capital, such as the value of buildings and capital stock, which can be monetised in case a company becomes insolvent. In structured credit, all you’ve got are the incoming cashflows from the underlying assets: once the cashflows dry up, you’re left with nothing else.

So why equivocate? Part of it was undoubtedly because the regulators let the financiers do it. Take a look at the pre-credit crisis version of the Basel II accord, an international treaty which governs, among other things, how much capital banks must keep on their books against certain types of credit risks. Sure, there’s a special section in Basel on so-called “synthetic” AAA-rated securities resulting from structured finance and how their capital charges should be calculated differently from corporate securities. But not differently enough: “the capital treatment of a securitisation exposure,” Basel said, “must be determined on the basis of its economic substance rather than its legal form.” As the MBIA lawsuit demonstrates, economic substance was hardly considered. So no wonder that banks were able to give their synthetic AAA claims the same risk weighing (20%) as allowed for corporate under Basel.

On the face of it, of course, they should have known better. Even without relying on Merrill, MBIA probably knew that ratings have a way of being off – just by their very nature. As Dimitris Chorafas explains in Economic Capital Allocation With Basel II, the step-ladder AAA, AA, A etc. gradations of credit rating agencies are hardly black-and-white distinctions. Instead, they come in what Chorafas calls “fuzzy sets” where a company rated AAA has a high possibility of being of that grade, but also a low possibility of being AA+, or one notch below, and so on. So even if MBIA took Merrill’s word as gospel, they sure didn’t allocate enough capital to the lower-probability outcomes. Result: under-priced services and over-exposure to risk.

But enough with the causes; what of the solutions? The sad truth is that they’ve been slow to come. It’s just this past July that the Bank of International Settlements, which oversees Basel, took steps to strengthen its so-called “three pillars” of governance. Chief among them are proposals to strengthen capital requirements for securitisations – i.e. end the fallacy of equivocation that allowed all the above-detailed financial arbitrage in the first place.

Will it work? Only time will tell. But for now, I’m tempted to side with Grebeck when he says that credit risk is about behavior – not models. It’s about time bankers were required to draw a hard line between the two.

Everyone has their favorite demon for the financial crisis, whether it’s mortgage originators, rating agencies, banks, the Fed, hedge funds or as some would have it, angry gods.

Then there’s some favorite policies, like mark-to-market accounting, that people like to point to as accuse of exacerbating the crisis and making it worse than it actually is.

Last week, I went to a panel discussion at NYU’s School of Professional and Continuing Studies – “Back to the Future: How NOT to Repeat Yesterday’s Mistakes in Tomorrow’s Markets” – with Jim Chanos, the hedge fund manager famous for shorting Enron before the fall. The event made me think twice about the role of hedge funds and mark-to-market accounting in this crisis.

Chanos was flanked by Ed Grebeck, a structured finance expert famous for warning investors not to put their money into collateralized debt obligations (CDOs) before the crisis (“Why Should Institutional Investors Invest in CDOs, at All?” – published in Euromoney in April 2006).

Grebeck made the point that mortgage-linked CDOs were crafted such that “your structured finance model is my equity risk”. That is, the depth of the CDO modeller’s research into historical housing prices and default rates was essentially what determined how risky of an investment it was for the buyer. As a result – all tranches, from the AAA-rated slices all the way down to the BBB mezzanine portions and the unrated equity portion – should have carried an equity risk premium. And the senior-most AAA portions certainly didn’t deserve risk equivalency with treasuries.

So they were, in effect, ticking time bombs of massively under-priced, illiquid securities that were loaded with irreconcilable conflicts of interest and didn’t give investors enough information about how they were pieced together.

Now, in hindsight, it is easy to see that. But what about 2004 through 2007, when these instruments were being mass-manufactured by investment banks?

All the biggest investment banks adopted FAS 157 – the financial directive that introduced mark-to-market accounting – in late 2006 or early 2007. The accounting standard required them to split their assets into three buckets – level 1 (which have observable market prices, like stocks) and level 2 (observable market prices, but model inputs are based on them, like interest-rate swaps benchmarked over a 10 year treasury bond) and level 3 assets (no observable market prices, so carrying values are based solely on management estimates).

In the spring of 2007, short-sellers such as Chanos, always looking at the fine print to determine whether it’s worth taking a bet that the price of a security will fall in value, for the first time had “better granularity into the financial system”, as he put it, thanks to FAS 157. Stock prices for all the big investment banks began to tumble because, for the first time people realized just how much exposure they had to those level 2 and 3 assets – the stuff Grebeck was talking about – and how heavily over-leveraged investment banks had become, he said.

So when I asked Chanos whether FAS 157 has exacerbated the crisis – since its introduction, people have argued that mark-to-market accounting is difficult, inaccurate, exaggerates losses and distracts management – he disagreed wholeheartedly. More disclosure is better than less disclosure, he said. He also called the CDO boom-and-bust “one of the biggest heists in the history of capitalism” essentially enabled by a lack of transparency.

And, naturally, he doesn’t believe that short hedge funds such as his – Kynikos Associates (Kynikos is Greek for “cynic”) should be vilified for making use of that information in making investments.

“It’s always easier to blame some nameless, faceless ‘they’ than face what got us here,” Chanos said.

But it will likely take a while for governments to get on the same page. He recalled giving a presentation at the G7 meeting in the spring of 2007 just as FAS 157 was being implemented. He and another speaker gave “60 minutes of horrific presentations” about what they saw coming in the financial markets. When they were done, the first question from the German finance minister, Chanos recalled, was, “thank you very much – now, what do you think about hedge funds?” – as if it were all their fault.

Which takes us back to the blame game all over again. Sure, there’s plenty to go around and the list of causes and culprits is still being tallied. But I, for one, am convinced that more disclosure and short hedge funds making use of that disclosure should stay firmly off the list.